Financial markets increasingly expect that the US economy, and the global economy in general, will enter a recession in the next 12 months, as the Russian invasion of Ukraine pushes the price of commodities, especially energy, upward.
But we think the main factor that could push the US economy into recession is not the Russo-Ukraine war itself, but rising inflation resulting from war-related production problems, as well as economic sanctions from Western countries.
In our view, the main factor driving the world into recession in the next 12 months will be tightening global monetary policy, which is increasingly likely given the rise in commodity prices. The energy crisis is also putting the global and Thai economies at risk of stagflation in the next three to six months.
The Thai economy in particular is likely to expand at a slower rate than the 3.6% previously expected.
At the March 15-16 Federal Open Market Committee meeting, we observed five signals suggesting US monetary policy would be more hawkish:
- The Fed raised its benchmark Fed Funds Rate by a quarter percentage point, to a range of 0.25% to 0.5%. It was the first hike in five years -- and one member even pushed for a half-point increase.
- The Fed is preparing to announce a balance sheet reduction, which has come to be known as quantitative tightening (QT), at its May meeting.
- Forecasts for future interest rate increases -- the so-called "dot plot" -- have increased from three times this year to seven, and to 3-4 times next year.
- US export forecasts have been downgraded, the unemployment forecast is unchanged while inflation expectations have been raised.
- Fed chairman Jerome Powell signalled the central bank was ready to continue raising rates amid a tight labour market, while not ruling out the possibility of some increases of more than 25 basis points if inflation remains high.
We are worried about the outcome of this meeting. In our view, there are four issues worth considering:
1. The Fed's dramatic revision of its 2022 economic growth forecast from 4.0% to 2.8% indicates that its oil price assumption is likely to rise beyond $100 per barrel, which would cause a sharp economic slowdown.
2. The revised inflation forecast from 2.7% to 4.1% and signals of a sharper upturn in rate hikes indicates the Fed wants to lower inflation expectations (currently at 4.9% over one year), suggesting growth deterioration.
3. We believe the US unemployment projection, which the Fed thinks will hold steady at 3.5% to 3.6% for three years, is unrealistic in light of shocks such as the Ukraine crisis and China's new Covid episode.
4. Finally, the "dot plot" forecasts are quite diverse this time. The gap between the projected lowest and highest interest rates for each year is 1.5 to 2 percentage points, versus about 1 point earlier, indicating a lack of consensus on the economic outlook. Hence, there is a possibility that the direction of US monetary policy could change -- either more accommodative or more restrictive.
The risk of policy mistakes is greater from continuous signalling of policy tightening. In hindsight, the Fed probably should have begun to raise its policy rate or taper its bond purchases in the third quarter of last year, when inflation was not as high and as persistent as now.
With the current "too little, too late" tightening, monetary policy now needs to be more restrictive, with tightening "front-loaded", meaning more and bigger rate hikes or other actions early on and a less restrictive approach as time goes by.
However, under the current policy path outlined by the Fed, rate hikes and QT, if carried out, will cause the 10-year bond yield to be higher than GDP growth from the second quarter of 2023 onward. We believe it is possible that a short-term economic recession or severe market downturn will result in the second half of 2023.
Furthermore, by studying the relationship between inflation and money supply growth in four economies, we found that US money supply (M2) rose the fastest. Growth reached 27% in February 2021 and has since eased to around 12% at present. On the other hand, in the euro zone, China and Thailand, money supply growth peaked at around 11% and fell back to between 5% and 9% in February 2022.
According to monetary policy theory, if an economy experiences a crisis that results in a decrease in velocity, then central banks must pump more money into the economy to prevent a downturn and deflation. But if the economy recovers, the rate of money velocity will increase. In such a situation -- as we are seeing now -- the central bank has to withdraw monetary injections instantly in order to keep inflation from rising.
However, US money supply remains high and continues to rise more than in any other country despite much higher inflation. This tells us that if the Fed wants to control inflation in the future, it must pursue tighter monetary policy than it is pursuing now.
With such a policy, world financial markets will be more volatile and financial crises could result in other places such as emerging markets. This is because US monetary policy affects other countries' monetary policies through exchange rates and capital movements.
When monetary policy must become tighter and more intense in the future, evidenced for example by the sharp rise in long-term bond yields or the inverted yield curve, this leads to increasing risk that the US economy will face a recession in the next 12 months.
The risk of a global economic crisis is greater, please be warned.
Piyasak Manason is senior vice-president and head of the wealth research department at SCB Securities, email piyasak.manason@scb.co.th
